ICRA Rating Feature

RATING METHODOLOGY
Methodology for Rating Mutual Fund Schemes
This rating methodology updates and supersedes ICRA's earlier methodology note on this subject, published
in January 2018.

What do the ratings of mutual fund schemes reflect?

Mutual fund ratings incorporate ICRA’s assessment of the creditworthiness of a debt mutual fund scheme’s
investment portfolio. These ratings are a symbolic representation of the credit risk in the underlying
investments or the degree of safety regarding the timely receipt of payments from the investments that have
been made by the mutual fund schemes. The ratings do not indicate the asset management company’s
(AMC) and/or any of its scheme’s willingness and/or ability to make timely redemptions to its investors. The
ratings do not address the market risks and hence should not be construed as an indication of the expected
returns, the prospective performance of the mutual fund scheme, and the ability to redeem the investments
at the reported net asset value (NAV) or the volatility in its past returns as all these are influenced by market
risks.

ICRA’s assessment of debt mutual fund schemes is guided by the credit ratings of the individual investments,
the relative share of the investments in the overall assets under management (AUM) of the scheme and the
maturity schedule of such investments. The relevant data for the above is obtained from the AMC and/or

December
public sources. In addition, ICRA engages in continuous dialogue with the representatives of the AMC such

June 2020
as the fund manager and/or product manager to understand their investment decisions and outlook during
the initial credit risk rating and for periodic monitoring thereafter.

ICRA’s mutual fund ratings are not a reflection of the quality of the management of the AMC or its financial
performance, reputation and other business practices including investment strategies, pricing, marketing and

February
distribution activities. Furthermore, the ratings are not a reflection of the adherence of the AMC or the fund

2016
to the regulatory requirements. These mutual fund ratings are suffixed by the ‘mfs’ symbol.

ICRA’s Rating Approach

Portfolio Credit Quality 2017
As a measure of the credit quality of a debt fund’s investments, ICRA uses the concept of credit scores. The
credit score is calculated by considering the weighted average credit risk of the portfolio with the market value
as the weight. These scores are based on ICRA’s estimates of the credit risk associated with each investment
in the scheme’s portfolio considering its maturity. To quantify the credit score, ICRA uses its database of
historical default rates for various rating categories across different maturity buckets.

At the outset, ICRA analyses the credit quality of the investment portfolio of a mutual fund scheme based on
the ratings outstanding.

❖ For debt securities, which carry an ICRA rating, the same is considered for the credit risk evaluation.
❖ For debt securities, which do not carry an ICRA rating but have ratings outstanding from other rating
agencies in India, ICRA may consider a different rating based on its own judgement. In case ICRA
is unable to form a view, it would consider the lowest public rating on the security.
❖ For debt securities which do not carry any ratings, ICRA takes a view based on the shadow/notional
rating of the debt instrument.
ICRA Rating Feature Methodology for Rating Mutual Fund Schemes

Using the above ratings and the residual maturity for each debt security in the portfolio, ICRA assigns a credit
score. In case of embedded put options in the debt instruments, the put option date is assumed as the
maturity date for such instruments. For two similarly rated papers, the default rate would be higher for the
paper that has a longer maturity and hence the tenure of the underlying investment can impact the credit
score of the portfolio. At each rating category, the default rates have been assumed to be the same for 3
years and beyond.

ICRA’s Credit Matrix

The credit matrix is a tool used by ICRA for analysing the investment portfolio of the debt mutual fund
schemes by assessing the portfolio’s aggregate credit quality while reviewing the credit quality of each
underlying debt security. The portfolio’s weighted average credit quality is then measured against the
appropriate benchmark credit score in the credit matrix.

Separate benchmark credit scores are used for short-term and long-term funds. Short-term funds include
overnight funds, liquid funds, ultra-short duration funds, low duration funds and money market funds and any
other funds with similar names. Long-term funds include schemes such as short duration funds, medium
duration funds, long duration funds and any other funds with similar names.

Hence, the short-term debt funds are those with weighted average portfolio maturities of up to one year,
whereas the long-term debt funds are those with a weighted average maturity of more than one year. ICRA
benchmarks the short-term debt funds against a 12-month benchmark credit score while the long-term debt
funds are benchmarked against the long-term benchmark credit score.

ICRA generally assigns short-term mutual fund ratings to short-term funds and long-term mutual fund credit
risk ratings to long-term debt funds. While arriving at the credit score, ICRA considers the long-term ratings
of the instruments in the portfolio. The mapping of the long-term-and short-term rating scale does not hold
for mutual fund ratings.

To assign a rating, the portfolio of the scheme is analysed at least for the last three months and the rating is
assigned on the basis of the credit score for the scheme for each of the last three months. For schemes that
are yet to be launched, ICRA discusses the proposed investment mix in terms of the credit quality that the
fund manager intends to maintain. Schemes, which are yet to be launched, are initially assigned a provisional
rating. Later, on the opening of the schemes for regular investments, the investment portfolio and its credit
score are benchmarked against the credit matrix to finalise the rating.

Ongoing Review and Monitoring

Once a mutual fund scheme is rated and the rating is accepted, ICRA reviews the underlying investment
portfolios for the credit scores on an ongoing basis. To this end, ICRA relies on the information provided by
the AMC and/or publicly available sources. ICRA reviews the mutual fund ratings on a monthly basis or as
and when required, which involves the evaluation of the portfolio credit score. If the portfolio credit score
meets the benchmark of the existing rating, the rating is retained. If the portfolio credit score breaches the
benchmark credit matrix score for the current rating, ICRA communicates the same to the fund
manager/product manager or other officials of the concerned AMC and may provide a month’s time to bring
the portfolio credit score within the benchmark credit score for the current rating level. If the investment
composition of the fund is realigned to bring the portfolio credit score within the benchmark credit score, the
rating is retained.

However, if the portfolio continues to breach the benchmark credit score for the existing rating level, the rating
is revised to reflect the change in the portfolio’s credit quality. In case of sharp breaches of the benchmark
credit score (for instance due to a multi-notch downgrade in the underlying investment) and/or if ICRA
believes that the breach may not get rectified within a month of the ongoing review, the rating is generally
corrected immediately without giving a month’s time for rebalancing the portfolio. If the AMC corrects its
portfolio post the rating downgrade of the scheme or the credit score improves in any manner subsequent to
the downgrade, making the scheme eligible for an upgrade, ICRA may consider an upgrade of the scheme
only if the scheme consistently maintains the credit score for a period of at least three months.

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ICRA Rating Feature Methodology for Rating Mutual Fund Schemes

In case an investment by the scheme is partly written-down by the AMC, ICRA continues to consider the
gross value1 of the investment for computing the credit score for a period until the scheme is able to seek a
full redemption of the amount or sells-off the investment. In case an investment is fully written-down, ICRA
continues to consider the gross value of the investment for computing the credit score for a period that is
earlier of the passage of at least six months from the date when such investment is fully written-down or until
the scheme is able to seek a full redemption of the amount or sells-off the investment.

ICRA has also observed that in the event of the rating downgrade of any instrument in the portfolio, large
investors (corporates or institutions) typically redeem their investments, whereby such redemptions are
generally met by the fund through the sale of better rated investments. In such a scenario, the share of the
downgraded instrument increases in the portfolio, leading to further deterioration in the credit score even
though there is no further change in the rating of the instrument downgraded earlier. Such events can also
lead to changes in mutual fund ratings.

The credit score of the fund can also deteriorate when some of the investments, which were previously written
down, are upgraded, but to a lower rating category and are hence written back by the AMC. In such cases,
the credit score is determined after excluding such investments and the fund manager is provided with a six-
month time frame to divest such investments to align the portfolio with the rating category. If such investments
remain a part of the portfolio even after six months, the credit score and the fund rating are determined after
including such investments in the portfolio.

In case of side pocketing2, for computing the credit score, ICRA continues to consider the gross value of the
investment which has been side pocketed for a cooling period of at least six months from the date of side
pocketing.

Summing Up

ICRA‘s mutual fund ratings are a symbolic representation of the degree of safety regarding the timely receipt
of payments from the investments made by the mutual fund schemes being rated. This opinion is arrived at
by computing the weighted average credit score based on the credit rating of the individual investments and
their tenure, which is then mapped to the appropriate benchmark credit score in ICRA’s credit matrix that is
developed on the basis of historical default rates for different rating categories across various tenures of
rated instruments.

1
Market value of the instrument before the multi-notch downgrade
2
Side pocketing is a mechanism introduced by SEBI in December 2018 to separate distressed, illiquid and hard-
to-value assets from other more liquid assets in a portfolio.

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ICRA Rating Feature Methodology for Rating Mutual Fund Schemes

Annexure

ICRA Mutual Fund Ratings: Scale and Definitions

ICRA’s Long-Term Debt Mutual Fund Rating Scale - This scale largely applies to debt funds with a weighted
average maturity of more than one year.

[ICRA]AAAmfs - Schemes with this rating are considered to have the highest degree of safety regarding the
timely receipt of payments from the investments made by them.

[ICRA]AAmfs - Schemes with this rating are considered to have a high degree of safety regarding the timely
receipt of payments from the investments made by them.

[ICRA]Amfs - Schemes with this rating are considered to have an adequate degree of safety regarding the
timely receipt of payments from the investments made by them.

[ICRA]BBBmfs - Schemes with this rating are considered to have a moderate degree of safety regarding
the timely receipt of payments from the investments made by them.

[ICRA]BBmfs - Schemes with this rating are considered to have a moderate risk of default regarding the
timely receipt of payments from the investments made by them.

[ICRA]Bmfs - Schemes with this rating are considered to have a high risk of default regarding the timely
receipt of payments from the investments made by them.

[ICRA]Cmfs - Schemes with this rating are considered to have a very high risk of default regarding the timely
receipt of payments from the investments made by them.

Note: Modifiers {‘+’ (plus) / ‘-‘ (minus)} can be used with the rating symbols for the categories [ICRA]AAmfs
to [ICRA]Cmfs. The modifiers reflect the comparative standing within the category.

ICRA’s Short-Term Debt Mutual Fund Rating Scale - This scale applies to debt funds with a weighted average
maturity up to one year. Such funds would generally include liquid funds and cash funds. The benchmark
maturity for this scale is 12 months.

[ICRA]A1mfs - Schemes with this rating are considered to have a very strong degree of safety regarding the
timely receipt of payments from the investments made by them.

[ICRA]A2mfs - Schemes with this rating are considered to have a strong degree of safety regarding the
timely receipt of payments from the investments made by them.

[ICRA]A3mfs - Schemes with this rating are considered to have a moderate degree of safety regarding the
timely receipt of payments from the investments made by them.

[ICRA]A4mfs - Schemes with this rating are considered to have a minimal degree of safety regarding the
timely receipt of payments from the investments made by them.

Note: Modifiers {‘+’ (plus)} can be used with the rating symbols for the categories [ICRA]A1mfs to
[ICRA]A4mfs. The modifier reflects the comparative standing within the category.

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ICRA Rating Feature Methodology for Rating Mutual Fund Schemes

Contact us for any feedback or comments at: methodologies@icraindia.com

ANALYST CONTACTS

Karthik Srinivasan Neha Parikh

+91 22 61143444 +91 22 61143426
karthiks@icraindia.com neha.parikh@icraindia.com

Niraj Jalan
+91 33 71501146
niraj.jalan@icraindia.com

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